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President's Speech
Presentation to the Bank of Korea’s International
Conference 2005 on The Effectiveness of Stabilization Policies
(Seoul, Korea)
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
of
San Francisco
For delivery May 27, 2005, 4:10 PM Seoul, Korea, 12:10 AM Pacific
Daylight Time, 3:10 AM Eastern
Challenges for Policymaking in a Changing Global Economy
Our discussion today about the effectiveness
of stabilization policies has been lively and informative. Importantly,
the task of judging how effective stabilization policies are likely to
be is complicated by the fact that we live in a changing world. Let me
focus on one of the underlying forces for change: increased globalization.
Thinking about increased globalization, by the way, is a relatively novel
situation for the U.S. to find itself in, but is not so novel for the
hosts and many others at this conference.
In my opinion, globalization is a net
positive for the world economy. Increased flows of goods, services
and capital across national borders
generally enhance efficiency and should help individual economies become
more flexible and resilient. But there are some costs as well; one
that pertains to monetary policy is that globalization makes it harder
to
see what’s driving the economic events that we have to deal with.
Let me give you two recent examples from the U.S. to illustrate what
I mean.
Long-term interest rates in the U.S. have actually fallen, despite
the fact that the FOMC has tightened policy eight times over the
past year.
Several possible explanations of this have focused on global developments,
such as increased purchases of government securities by Asian central
banks and a worldwide excess supply of savings. But it is difficult
to gauge the magnitude of these effects, and, as far as I am concerned,
low long-term rates are still a “conundrum,” to borrow
a term that Chairman Greenspan has used recently.
The relatively low
levels of inflation that prevailed over the past decade provide
another example of how increasing globalization may
be changing
the dynamics of the economy. Some have suggested that the Phillips
curve has shifted, perhaps owing to the effects of increased globalization.
Following a somewhat different logic, Ken Rogoff1 suggests a role
for increased globalization in the nearly simultaneous decline
in inflation
across many countries.
I could add more examples from the U.S. (such
as puzzles relating to the current account deficit), just as I am sure
you could from
your
own countries. The general point I want to make is that developments
like
increasing globalization and financial liberalization have changed,
and continue to alter macroeconomic linkages, perhaps in fundamental
ways.
As a result, there is more uncertainty in the economy, and that’s
an environment in which it is even harder for policymakers to
determine the appropriate responses to economic events.
What does
this mean for monetary policy? We have heard Bob Rasche
talk about the uncertainty faced by monetary policymakers and
express doubts
about the effectiveness of stabilization policy. He is not
alone in expressing such doubts, of course, but is following a tradition
that
features Milton
Friedman as one of its luminaries. Indeed, some economists
take
this position to an extreme, believing that uncertainty, both
about the
current and likely state of the economy and about the effects
of monetary policy
on the economy, is so overwhelming that policymakers should
be humble and focus on only one thing: inflation—which is what
the Fed can
undeniably control in the long run. This approach is often
referred to as “strict
inflation targeting.”
But I, for one, am not a strict
inflation targeter. I do not subscribe to the dismal conclusion
of this approach. And—as far as policymakers
go—I do not think I’m in the minority. Certainly,
the Federal Reserve Act is more optimistic: as you well know,
the Federal Reserve
is charged with assuring both maximum employment and price
stability. I do not mean to deny that there is a debate—both
in academic circles and outside them—about how these
objectives should be ranked relative to each other and about
the ability of monetary policy to achieve them.
But I have a hard time believing, for example, that the FOMC’s
accommodative policy stance following the last recession
has not helped support the subsequent recovery. I have discussed
some of the issues
in this debate in detail elsewhere;2 for now, let me just
say
that I think we can and should pay attention to both objectives.
Furthermore,
I would argue that the Fed has successfully done so over
the past two decades. Indeed, these objectives are interconnected
in important ways,
as I will describe momentarily.
I think the right approach
to dealing with uncertainty is
for policymakers to increase the clarity with which they
convey
to the public both
monetary policy objectives and strategy. Monetary policy
affects the economy
not primarily through short rates, but instead through its
effects on asset
prices, including bond rates and equity prices. If financial
markets have a good understanding of the central bank’s
objectives and strategy, they will react appropriately to
policy moves. This allows
markets and policymakers to work together rather than at
cross purposes—strengthening
the transmission mechanism and shortening policy lags.
One
important way to contribute to the public’s understanding
of policy is for a central bank to act in a systematic manner
in its response
to changing economic conditions. Over time, market participants
will observe the central bank’s reaction to news and
will come to understand the determinants of policy. As a
result, they will correctly anticipate
policy responses to new information, in a way doing the work
for the central bank.
This process can be accelerated through
central bank communications that explain policymakers’ views
on the economy and provide insights into the key determinants
of monetary policy, especially during periods
when policy may need to deviate from its usual pattern. In
this I agree with what Marvin Goodfriend said about the benefits
of enhanced transparency
and communication in monetary policy.
A look at the recent
historical record shows that the FOMC has become more communicative
of late. In 1994, it added
descriptions of the
state of the economy and the rationale for the policy action
to the post-meeting
press release. In January 2000, the FOMC introduced a statement
describing the “balance of risks” to the outlook,
and in March 2002, it began releasing the votes of individual
Committee members and the
preferred policy choices of any dissenters. In August 2003,
the Committee added explicit forward-looking language concerning
future policy into
its statement. More recently, it decided to expedite the
release of its minutes so that the minutes of each FOMC meeting
are now issued three
weeks after the meeting, providing the public with a more
nuanced understanding of the various views within the Committee.
I strongly believe that all
of these measures to increase transparency have improved
the effectiveness of policy.
A natural next step for the FOMC
is to contemplate providing even clearer guidance to markets
by announcing an explicit
numerical long-run inflation
objective. Unlike many other central banks around the world,
the
FOMC does not have an explicit numerical inflation objective
or range, though
we have discussed this issue at FOMC meetings a number of
times in the past, most recently in February.
These discussions
have highlighted the significant benefits and costs associated with
such a move. It would be helpful
for the
FOMC because
it would facilitate both internal discussions and external
communication. More importantly, it could help anchor the
public’s expectations.
One recent study has shown that an inflation target coupled
with an increase in operational independence for the Bank
of England has led to a reduction
in the response of long term interest rates to shocks.3 This evidence implies that inflation expectations are better
anchored
now. It also
makes me somewhat more optimistic about the value of an
explicit numerical inflation objective than I would be
if I were only
to look at the evidence
marshaled by Bob Rasche about the similarities of inflation
rates across countries that do and do not announce such
objectives. Of course, this
is an area of active research and I realize that the jury
is still out.
One important advantage of well-anchored inflation
expectations is that it can give the central bank the freedom
to react
to other developments
(such as an oil price shock, a recession, or financial
market turbulence) without raising concerns about its commitment
to price stability.
Indeed, well anchored inflation expectations are likely
to
give the Fed greater
freedom to accomplish the other part of its mandate: maximizing
employment.
Recent developments have highlighted another
extremely important reason why well-anchored inflation expectations
are important—they may
help us avoid deflation. We have long known that inflation
can be too high,
but the recent experience of Japan has reminded us that
inflation can be too low as well. We know from history
that such an
outcome can be
extremely damaging to the economy.4 Perhaps
the most unsettling aspect of the Japanese experience
is the evidence on
how difficult it can
be to get out of a deflationary situation.
This is an
important reason why the FOMC became so alarmed about the level and
trajectory of U.S. inflation roughly
two years
ago. In statements
issued over the May 2003 to October 2003 period, the
FOMC referred to “…an
unwelcome fall in inflation…” and worried
about “…the
risk of inflation becoming undesirably low…” Many
people have interpreted these statements as signaling
a lower bound for the
amount of inflation the FOMC will accept. To the extent
that this is true, articulating an explicit numerical
long-run inflation objective
might not appear to be a very big step.
Of course, there
are potential costs to such a move as well. One is
the possibility of miscommunication
regarding
our
dual objectives.
In particular,
one concern, which I share, is that some may misinterpret
the enunciation of a long run inflation objective as
a down-weighting of the Committee’s
mandate to foster maximum employment. To reduce the
risk of such an outcome, the announcement of any numerical
inflation objective should be made
in the context of clear and effective communication
of the Fed’s
multiple goals. Here, I am drawn to some specific language
proposed by Governor Bernanke: “the FOMC regards
this inflation rate as a long-run objective only and
sets no fixed time frame for reaching it. In particular,
in deciding how quickly to move toward the long-run
inflation objective,
the FOMC will always take into account the implications
for near-term economic and financial stability.”5
Another
concern is that the announcement of a numerical objective
could lead to a change in the way policy
is conducted, with
excessive weight
placed on the measurable goal—which is inflation—relative
to the hard-to-measure ones such as full employment,
thus leading to de facto strict inflation targeting.
However, as I noted above, I believe
the opposite, namely, that a credible inflation objective
would actually allow the FOMC more room to focus on
stabilizing output, because it would
not have to worry about the adverse effect that its
attempts to stabilize output might have on inflation
expectations.
Overall, while I am mindful of the potential
costs of announcing an inflation objective, I conclude
that
the
benefits outweigh
the costs.
Such a step
could enhance the effectiveness of monetary policy
not only for controlling inflation but also for stabilizing
the economy.
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